The Federal Reserve’s gradual raising of interest rates is increasingly impacting the financial stability of emerging market economies. A decade of low interest rates in the West has fueled a surge of dollar-borrowing in emerging markets, as investors seek higher yields. As investors retreat from emerging markets, signs of economic weakness in several countries have begun to surface. The Turkish economy has fallen victim to this development, with its currency, the Turkish Lira, steadily declining against the dollar throughout 2018. Events have taken a more dramatic turn of late, and the collapse of the Turkish Lira has rapidly accelerated over the past several months.
Many have seen this year’s slow motion collapse of the Turkish Lira, along with surging inflation, as a sign of an imminent correction happening across emerging markets. The Turkish Lira has roughly halved in value over the past year, with the decline accelerating following recent geopolitical tension and trade worries. While rising interest rates will continue to put pressure on heavily indebted emerging market borrowers, Turkey’s quickening economic collapse is more the result of its own idiosyncratic problems.
Once a darling of emerging market investors, Turkey’s economy was flooded by cheap dollar credit throughout the past decade, as investors hunted for higher yields farther from home. The influx of cash fueled a long economic boom. Construction and infrastructure projects increased, benefiting from a perceived coziness between the President Recep Erdogan’s administration and the construction industry. Istanbul’s skyline has been reshaped as a result, and cheap credit has funded gargantuan projects such as the 1,100-room presidential palace and the world’s newest, largest airport outside of Istanbul.
Turkey’s long construction boom has been financed largely by USD and EUR denominated loans. The collapse of the Turkish Lira has effectively doubled the interest rate burden for many developers in Turkey, who receive revenue only in the domestic currency. Inflation has surged, squeezing the lower and middle classes who lack access to hard currency. Shortages of key consumer goods are on the horizon, with hospitals increasingly unable to come up with the hard currency required to purchase medicine.
While on the surface Turkey appears to be yet another struggling emerging market economy being squeezed by rising dollar interest rates, its current situation is, in fact, far more perilous. In addition to rising dollar rates, the collapse of the Turkish Lira has been spurred on by the quickening collapse of Turkey’s institutions and the increasingly arbitrary and autocratic rule of President Erdogan.
During the past decade, Erdogan consolidated power while using the economic expansion as political cover. The most recent election in Turkey saw the country transition from a Parliamentary system to a Presidential system. Under the new presidential system, Erdogan exercises an enormous amount of control over the political system.
The hollowing of institutions and centralization of the political system has increased fragility and instability in Turkey. In 2016, a coup attempt took place and Erdogan as well as his allies were ultimately able to seize back control of the government. The coup attempt provided justification for further power grabs by Erdogan and his allies. The coup’s inept execution led to widespread speculation that it was a false flag operation by the government seeking a pretext for the purging of an alleged “deep-state,” riddled throughout Turkish society.
The installation of Erdogan’s son in law, Berat Albayrak, as the Minister of Finance only a month after Erdogan’s most recent electoral victory rattled investors. Albayrak’s appointment removes a critical institutional break that has prevented Erdogan from implementing some of his more unorthodox beliefs. For instance, Erdogan believes higher interest rates cause inflation. Erdogan has been working to bend the once staunchly independent Central Bank into holding rates low and has been waging an increasingly public campaign to curb the bank’s independence.
The currency crisis has quickened in recent weeks, spurred by an increasingly fraught relationship with the Trump Administration, and the Turkish regime’s increasingly unorthodox approach to containing the crisis. The imprisonment of an American pastor from North Carolina has drawn the ire of the Trump Administration. Tariffs, as seems inevitable now, soon followed.
The spat with Trump led to the imposition of steel and aluminum tariffs, but investors found the increasingly unhinged reaction of the Erdogan Administration far more worrying. In the face of the currency’s collapse, Erdogan has resorted to tin-pot attempts to stabilize the situation. Attempts to convince the population not to sell their Turkish Lira have failed, as they often do in these situations. Ominous hints of currency and capital controls have been floating around the markets, which have only fueled the fire of selling.
On September 13, the Turkish Central Bank succeeded in increasing rates in an effort to tamp down inflation, despite public exhortations by Erdogan the same day that high interest rates were “tools of exploitation.” The interest rate rise was matched by a decree from the government banning domestic use of dollars and euros for trades, highlighting the increasingly incoherent government response on the crisis. While the interest rate rise succeeded in stabilizing the Turkish Lira’s value, Erdogan’s increasingly public war with his Central Bank is perhaps the more important story.
Despite the recent stabilization, Turkey’s crisis is far from over. The man who put the country on the path to crisis will likely be the ultimate arbiter of his nation’s fate.